Investment advisors and managers are subject to certain requirements under law to ensure that the trades they execute are reasonable, such as under the Employee Retirement Income Security Act of 1974 (“ERISA”). Under ERISA, a fiduciary must discharge his duties, including the duties related to brokerage selection, “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man would use in the conduct of an enterprise of like character and with like aims.” ERISA §404(a)(1)(B). This fiduciary duty is commonly referred to as the prudent man rule. Under ERISA many brokers and dealers may qualify as fiduciaries because the Act defines a fiduciary as a party that: (1) exercises discretionary authority or control with respect to the management of the plan or the management or disposition of plan assets; (2) renders investment advice, with respect to plan assets, for a fee or other compensation (or has the authority or responsibility to render such advice); or (3) has discretionary authority or responsibility in the administration of the plan. Thus, for example, managers responsible for employee plans or who provide advice with respect to employee plans are typically considered fiduciaries with a duty to comply with the prudent man rule.
Fiduciaries must also comply with the “exclusive benefit rule” under Internal Revenue Code §401(a)(2). The exclusive benefit rule states that an ERISA plan must be operated for the exclusive benefit of its participants and their beneficiaries. The Department of Labor in an Information Letter issued to Refco, Inc. (Feb. 3, 1989) indicated that the prudent man rule, along with the exclusive benefit rule, impose upon a fiduciary the duty to obtain the best execution available in securities transactions and to monitor: (1) the quality of services provided by the broker; and (2) the reasonableness of commissions in relation to the totality of services received by the plan.
Recently the investment community has suffered from challenges to its integrity. For example, the mutual industry has suffered many scandals in recent years based on the execution of trades at the end of the day at off market prices, i.e., below the best price available on the market at the time of execution. Compliance officers and boards are now faced with the dilemma of what to do to ensure that plan managers fulfill their fiduciary duty to obtain the best price for any execution.
There are thus a wide variety of individuals and entities that have a fiduciary responsibility to ensure that the prices at which they buy or sell financial products are the best possible prices available. Normally this is done by requiring that every order have at least three possible sources of prices, or by using automated electronic platforms with an audit trail of execution. In addition, in order to ensure compliance with fiduciary duties, companies may hire consultants to review their traders' transactions for reasonableness. Consultants are able to compare specific transactions against historical data, as transaction data is commonly stored as time series by data vendors, however this data typically does not contain volume-traded information by price point. For example, stock prices are maintained by data providers (Reuters, Bloomberg, and even Yahoo! Finance) and used for graphs and charts, normally for displaying historical price movement and for technical analysis. Reviews currently are conducted by manually comparing a transaction to the chart of the price data of the security bought or sold. However, as noted above, these databases do not record trade size, and thus are of limited use to ensure compliance with fiduciary duties.